I am not a big believer in market analogues, but the current environment bears an eerie resemblance to the summer of 2011. Here are the similarities

Heavy insider selling
I wrote back in early February (see Insider selling, it’s baaack!) that insider selling was surging. Vickers reported that [emphasis added]:

Looking at a longer time frame paints a bearish picture as well. The eight week sell-buy ratio from Vickers stands at 5-to-1, also the most bearish since early 2012. What’s more, the last time this ratio was at these levels was June 2011, just before another correction in the stock market took place.

Apparently, insider selling has gotten worse since that report. According Charles Biderman of TrimTabs (via Zero Hedge), the ratio of insider sales to buys is skyrocketing, though I am unsure of how to compare the Vickers sell-to-buy ratio to the TrimTab’s one as I don’t know the differences in their methodologies:

While retail is being told to buy-buy-buy, Biderman exclaims that “insiders at U.S. companies have bought the least amount of shares in any one month,” and that the ratio of insider selling to buying is now 50-to-1 – a monthly record. “So far the mass delusion is holding.”

By contrast, Bloomberg reports a three-month average insider sales-to-buy ratio of 12 to 1, a two year high:

There were about 12 stock-sale announcements over the past three months for every purchase by insiders at Standard & Poor’s 500 Index (SPX) companies, the highest ratio since January 2011, according to data compiled by Bloomberg and Pavilion Global Markets. Whenever the ratio exceeded 11 in the past, the benchmark index declined 5.9 percent on average in the next six months, according to Pavilion, a Montreal-based trading firm.

Regardless of differences in methodology, the results are an ominous sign for the bull camp.

US political gridlock
Another similarity between today and the summer of 2011 is the rising anxiety over the consequence of political intransigence in Washington. Then, we saw the debt ceiling crisis of 2011, which led to the loss of the AAA credit rating from Standard and Poor’s.

Today, we have $85 billion in overnight sequestration cuts to the federal government and a looming debt ceiling crisis on March 27, about three weeks away. Fed chair Ben Bernanke projected that sequestration will likely slice 0.6% from GDP growth in 2013:

However, a substantial portion of the recent progress in lowering the deficit has been concentrated in near-term budget changes, which, taken together, could create a significant headwind for the economic recovery. The CBO estimates that deficit-reduction policies in current law will slow the pace of real GDP growth by about 1-1/2 percentage points this year, relative to what it would have been otherwise. A significant portion of this effect is related to the automatic spending sequestration that is scheduled to begin on March 1, which, according to the CBO’s estimates, will contribute about 0.6 percentage point to the fiscal drag on economic growth this year. Given the still-moderate underlying pace of economic growth, this additional near-term burden on the recovery is significant. Moreover, besides having adverse effects on jobs and incomes, a slower recovery would lead to less actual deficit reduction in the short run for any given set of fiscal actions.

A 0.6% slowdown in GDP growth could very well mean that the economy stalls and keels over into recession. What’s more, another debt ceiling debate with a drop-dead deadline of March 27 will pour gasoline on the fire and could lead to further market anxieties.

Risk-off, anyone?

News cycle turns down in Europe
In 2011, the ECB’s announcement of its LTRO program stabilized the markets. Mario Draghi’s “whatever it takes” remark in July 2012 and the ECB’s subsequent OMT program contributed to further stabilization. Today, the market consensus has evolved to the view that the ECB has taken tail-risk, or the risk of a European sovereign debt or banking crisis, off the table. The ECB, it seemed, had built a financial castle wall around the eurozone again.

Read the fine print. The OMT program depends on member states submitting to the ECB’s “conditionalities”, namely austerity and structural reform programs. The rise of anti-euro forces in the recent Italian election shows how fragile the ECB’s castle walls really are.

I fear that the news cycle is about to turn down in Europe. Consider these stories that are appearing:

The divergence between German and French economies (via Business Insider). This divergence is starting to raise the question of the viability of the French-German partnership in the EU. These are the two principal founding partners in the European Union and brings up the question of wage and productivity differentials between the two countries. If the two economies can’t converge and Germany is unwilling to subsidize France, the euro is cooked. Nothing else matters. It doesn’t matter what happens to Greece, Spain, Ireland, etc.

Political turmoil in Spain. The FT reports that Madrid is pushing for a constitutional challenge to Catalonia’s bid for independence, which puts the spotlight on political stability in Spain:

The Spanish government has launched a legal challenge against Catalonia’s recent “declaration of sovereignty”, in the latest move by Madrid to halt the region’s march towards independence.

The government said it would ask Spain’s constitutional court to nullify the Catalan parliament’s January declaration, which stated that the “people of Catalonia have, for reasons of democratic legitimacy, the nature of a sovereign political and legal subject”.

What’s more, Business Insider reports there are rumblings that the Army may not stand idly by and the possibility of a coup d’etat is raising its ugly head. While I believe that these risks will ultimately resolve themselves in a benign fashion, these stories are just further signs that the news cycle is turning negative in Europe.

Recall that in 2011 we had angst over Greece and the implications for the eurozone. We saw endless summits and crisis meetings until the ECB stepped in to stabilize the situation. Today, the fragile peace that the ECB has put together is starting to unravel. Europe is in recession and the tone of the news stories are turning negative.

These kinds of stories have a way of not mattering to the markets until it matters, especially when the market is in risk-on mode. Now that the tone seems to be moving away from a risk-on to risk-off, the market has a way of focusing far more on this kind of negative information.

A positive divergence
In 2011, the SPX cratered about 17% in response to these anxieties. While I am not saying that the downside could be the same, it is nevertheless a warning for the bulls. The key difference between the market weakness in 2011 and today is how the Fed acted then and now. In 2011, the Fed’s QE program was just ending, while we are seeing QE-Infinity today. The actions of the Federal Reserve today may serve to cushion the effects of the speed bumps that the equity markets are likely to experience.

Nevertheless, the current environment is likely to be more friendly to the risk-off crowd than the risk-on crowd.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The FOMC did exactly what we and many others suspected they would do yesterday—nothing! Washington did exactly what we thought they would do yesterday—waste time and money. Congress went through the motions to pass an extension of the “Bush” tax cuts so that when they are out politicking for votes in the coming months, they can blame the Democrats for not supporting the Bill.

The market should be somewhat disappointed that the ECB did not confirm or detail the bond buying plan. However, it had little response to the rate announcement and is waiting for the press conference, and perhaps Friday’s NFP report. A weak close Friday with 2/3rds of earnings in the bag (read the good news side) will turn the focus back to the global macro risks, which as all will know is a #()%!#$ mess. Aggressive traders can be short at the end of the weak if we close below 1375, a close above 1395 suggests a retest of the May highs.

A quick comment on yesterday’s mini “flash crash” caused by Knight Trading—expect more of the same as even more computers trade with computers.

So commodities are bouncing a bit based on the expectation the ECB is about to launch a major QE effort to reduce borrowing costs in Spain and Italy. Gold has responded by breaking out above a 4 month trendline of lower highs and should be able to test the upper resistance in the $1655 to $1690 range. The 200-day average is at $1655, but it is not seen as an important level. The 50% retracement from the Feb high to the May low is at $1659 with $1690 the 61.8% retracement. The declining trendline of the 2011 and 2012 highs projects into the $1680 area today and is declining at about $1 per day.

Gold stocks continue to see significant earnings impairments from exponentially rising costs, so if gold cannot make a material move above this overhead resistance, gold stocks are unlikely to do much better than a retest of nearby resistance areas either. NEM missed big today just like ABX did yesterday. However, seasonals are bullish for the sector for the next few months, so a buy dips bias makes sense.

We continue to expect the risk-on, risk-off markets to dominate trading until further notice—global economies are slowing and stimulus is expected. Last week’s response to the trifecta of an ECB rate cut, a Chinese rate cut, and a material increase in QE from the BoE was poorly received. We expect the trading ranges of the past year to generally contain the market for the next few quarters.

The rally in WTI was stopped dead in its tracks last week and our call to take some money off the table in the sector was right on the money. For now, we do not see WTI dropping back below recent lows around $78, but we do not see it getting back above $90 unless there is an escalation of tensions in the Strait of Hormuz and a real supply squeeze, we do not see a demand pull for a while—these things are hard to forecast with any certainty.

The gold sector has had the biggest volatility of all as investors await QE or not QE, that is the question. Seasonality for gold stocks begins to look really good over the next few months, so buying dips in the sector is back on the front burner.

The fact that the TSX underperformed so miserably yesterday made little sense to us. The tape in the US clearly showed that risk was back on as the market gets excited about a global central bank coordinated intervention for European debt and that Greece will vote with a bias to remain in the EMU. That should mean the market losses some anxiety at least and starts to focus back on earnings, which will be no picnic to be sure, but better than focusing on the world’s banks falling apart.

The European banks are trading stronger this morning and have not made lower lows this week—a notable sign of stability. If the ECB comes with a big bazooka, the improvement in psychology could last for a few months as it has in the past. It seems like this time, the band-aid solution actually makes some sense if they can pull it off. We just might be surprised at how high the bounce could be and how long it could last. For the TSX though, we really need to see the world growth outlook improve for commodities, and we fear 2013 will hit the US pretty hard, so it’s a bounce in what likely is a continuing bear for global growth.

Well, that market reaction to the Spanish banking bailout was underwhelming! I wrote last week that seeing a market’s reaction to an event can be an important clue to future direction, as it is an indication of investor expectations and what news is priced in.

We now know the path of least resistance for stocks is down. We got the first hint last week from the lukewarm market reaction to the ECB announcement and Draghi press conference; and later the reaction to the Bernanke testimony (see my comment Is the QE glass half full or empty?).

Now that the bias for equities is bearish, what’s the short-term downside from here? Consider this note from Todd Salamone of Schaeffer’s Research published on the weekend, which suggests that technical selling by option market makers could exacerbate the downturn as we draw closer to Friday’s option expiry [emphasis added]:

The current open interest configuration on the SPDR S+P 500 ETF (SPY – 133.10) is very put-heavy, setting up the potential for short-covering related to the expiring put open interest at strikes immediately below the current SPY price. The odds are in the bulls’ favor, absent a negative outcome with respect to Spain over the weekend. That said, a poor start to the week spurred by ongoing euro-zone concerns could create the kind of delta-hedge selling that occurred last expiration month, when put strikes acted as “magnets” once the ball got rolling to the downside.

Here is how he explained the mechanics of delta hedging as it related to the option market and market makers may have contributed to the market decline in May:

As popular put strikes were violated one after another during expiration week, sellers of the puts may have been forced to short futures to keep a neutral position, creating a steady but sure stream of selling. The heavy put open interest strikes essentially act like “magnets,” as one strike after another is taken out. Delta-hedging risk certainly grows during expiration week if the market gets off to a weak start, as it did last Monday, and there is heavy put open interest just below current prices.

Salamone postulated that the SPX could find some support at the 1,280 and 1,250 level:

It’s usually the big put strikes that act like magnets, so 128 (which corresponds to SPX 1,280) would be a possible support area. There’s a smaller-probability risk of a move down to 125 (or SPX 1,250), which is the next strike with significant put open interest. On the upside, a move into heavy call strikes at 134 and 135 would be a possibility in the event of a short-covering rally. These areas correspond to SPX 1,340 and 1,350, respectively, which we cited above as potential chart resistance.

Given Monday’ market action, it is evident that the bears have the upper hand. Salamone’s comments put some further context to the short-term downside that US equities face this week.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The TSX is developing a degree of an oversold bottoming pattern, but the fundamentals looking out for several quarters suggest that this is not likely the cycle low for this market decline that started in 2011. The giant band-aid that the ECB is going to place on Spanish banks could pacify the markets for a while, especially if Greece votes to stay in the EMU next week.

We saw S&P reaffirm the negative watch in the US, but suggested that any further downgrades would not come until closer to 2014 after the new administration gets a chance to tackle the longer-term debt issues. In the mean time, the reserve currency status and their ability to print money and monetize debt should tide them over.

The market could bounce a bit more than some expect, and for the TSX, it depends on the “risk on” trade and how commodities play out. The initial reaction on Sunday evening was a 2% plus jump in copper and crude, with a 1.5% jump in S&P 500 futures, faded once European banks opened for trading today.

This week is an important week for investors who are watching for central bank action in the wake of market angst over Europe and the American economy. On Wednesday, the ECB will announce its interest rate decision and Mario Draghi will hold the customary press conference afterwards. On Thursday, Ben Bernanke will be testifying before Congress.

What will they say?

Don’t expect too much
While I do expect that the ECB and Federal Reserve will intervene eventually, I do think that the markets may be getting ahead of themselves in anticipating another round of LTRO from the ECB or QE from the Fed. After all, Mario Draghi said last week that the ECB was reaching the limits of what it could do and it’s now up to the politicians:

Draghi told a European Parliament committee in Brussels that without more aggressive action by policy makers the euro “is being shown now to be unsustainable unless further steps are being undertaken.”

He said it wasn’t his job to make up for the failures of policy makers. “It’s not our duty, it’s not in our mandate” to “fill the vacuum left by the lack of action by national governments on the fiscal front,” on “the structural front, and on the governance front,” he said.

The ECB is likely to reduce interest rates in the face of economic weakness in the eurozone, but don’t expect too much more. If Draghi were to reverse course from last week and announce some extraordinary measure like another round of LTRO, it would not only erode the ECB’s credibility, but could paradoxically have a negative effect on the markets as it asks, “What looming disaster does the ECB know about that we aren’t aware of?”

QE3 in June?
Across the Atlantic, there is a lot of expectation built up that we are due for another round of QE at the June FOMC meeting in the wake of last week’s ugly NFP report. Veteran Fed watcher Tim Duy disagrees [emphasis added]:

Bottom Line: At this point, the direction of US data, the pathetic state of Europe, and the evolving slowdown across the rest of the world all point toward additional action by the Federal Reserve. Assuming this continues, it is an issue of timing and tools. My baseline is steady policy at the June meeting (depending, of course, on the usual financial turmoil disclaimer), with a possibility of an extension of Operation Twist. The latter option is something of a tough sell for me; it is cheap, but will prove to be ineffective. If the Fed needs to move, they need to reverse course back into quantitative easing. They need time to build internal support for such a move, which argues for action later in the summer or early fall, much as we have seen in the past two years. I just don’t think they have enough to shift policy at this juncture.

Don’t forget that Bernanke and the Bernanke Fed is made up largely of conservative academics, who tend to wait for definitive evidence of a slowdown before acting. As I wrote before about the difference between the Bernanke and Greenspan Fed (see Yes to QE3, but not yet), both the Greenspan Put and Bernanke Put exist, the difference is in reaction time:

[P]ut yourself in Bernanke’s head. His academic reputation was built on the study of central bank action during the Great Depression. This is probably a little voice in his head telling over and over again, “Don’t let another Great Depression happen on your watch.” As a result, we have the Bernanke Put.

Greenspan had a long career on the Street as a forecasting economist and tended to be more proactive:

Greenspan’s approach as Fed Chairman was to stimulate whenever he saw signs of weakness – and he was far more market savvy than Bernanke. Therefore the Greenspan Fed tended to be more proactive and tended to get ahead of events. The Great Moderation was the result of the Greenspan Put – and those policies worked well, until they went overboard with the stimulus (and we are still paying the price for those policies).

My guess is that investors looking for hints of another round of QE from the Fed on Thursday are likely to be disappointed.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

2012 = 1998?

Posted: 04 Jun 2012 12:16 AM PDT

Weekends are a good time to think and reflect. After last week’s carnage in the stock market, some thinking and reflection was more than overdue. The question I had was, “What is the market headed?”

When I consider the different dimensions by which investors evaluate equities, they present a mixed picture that is, while bearish, does not point to disaster:

Sentiment: bullish

Valuation: neutral to slightly bearish

Momentum: bearish

Macro: bearish, but subject to policy-induced whipsaw

Sentiment models are screaming “buy”!
Let’s go through each of these one at a time. Martin T. over at Macronomics noted that Wall Street strategists are off the charts bearish, which is contrarian bullish.

As well, US 10yr yields are trading 3 standard deviations from the 30+ year downtrend, which indicates a crowded long in the Treasury safe haven trade.

If I had to sum up what all this means, I would say that the evidence of market prices points to a very high level of fear, uncertainty and doubt among global investors. Today’s record-low 10-yr Treasury yield is just the latest sign that investors are consumed by fears. When emotions reach such heights, as they did in the early 1980s and in late 2008/early 2009, investors willing to bear risk stand a good chance of being rewarded, provided the future turns out to be less awful than the market expects.

Valuation: Neh!
Typically, when sentiment is this bearish, Value investors are all crawling out of the woodwork and shouting, “I can’t believe that there are so many bargains!”

While I have heard that comment directed at a number of European companies, i.e. these are real world-class companies trading at bargain prices (see one example at the FT article While all around ar panicking…buy), the same couldn’t really be said of most markets. The Value investors just aren’t there.

Consider, for example, this Barron’s interview with Jeremy Grantham, who is known to have a value bias, on February 25, 2012 when the SPX was about 1360, which is about 6% above Friday’s close of 1278.

We do a seven-year forecast every month. On a seven-year forecast, global equities outside the U.S. are boring. They’ve been so nervous the last year that they mostly reflect the right degree of fear about European problems. Emerging markets and developed markets outside the U.S. are within nickels and dimes of fair value. This is very unusual. We are in the asset-allocation business, and we like to see horrific roller coasters: It gives us something to get our teeth into. What could be more boring than global equity markets at fair value?
About a quarter of the U.S. equity market—the high-quality, boring, great companies—is about fair price, too. The other three quarters are overpriced, and based on our numbers have a slight negative imputed return.

While Grantham doesn’t represent the final word in stock market valuation, he is a good bellwether for what Value investors think. As of the end of February, he believed that non-US equities were roughly at fair valuation. US equities are overpriced, with only a quarter, i.e. high quality stocks, at fair value.

His comments were not a stunning endorsement for the stock market.

A Dow Theory sell signal
The Dow Theory is one of the original trend following models, which is based on price momentum and looks for confirmations from different sectors of the market: industrials, transportation and utilities. Long-term market analyst and Dow Theorist Richard Russell recently flashed a major sell signal for stocks [emphasis added]:

IMPORTANT — Dow Theory — The D-J industrial Average recorded a high of 13,279.32 on May 1, 2012. This Dow high was not confirmed by the Transports. The two averages then turned down and broke below their April lows. This action confirmed that a primary bear market is in progress — it was a textbook bear signal.

Could you be a little more clear, Richard?

Macro picture gets worse
Last week, the news flow from Europe continued to deteriorate. The latest Greek tracking polls have SYRIZA on top again:

Not only that, the markets are now getting concerned about Spain – a country that’s too big to fail. In the meantime, ECB head Mario Draghi stood aside last week and said that the ECB can’t do much more. It’s all up to the politicians:

Draghi told a European Parliament committee in Brussels that without more aggressive action by policy makers the euro “is being shown now to be unsustainable unless further steps are being undertaken.”

He said it wasn’t his job to make up for the failures of policy makers. “It’s not our duty, it’s not in our mandate” to “fill the vacuum left by the lack of action by national governments on the fiscal front,” on “the structural front, and on the governance front,” he said.

Last week, I wrote that investors should focus on China, not Europe. The news out of China is headed south. The latest PMIs are signaling a global slowdown, not just in China but in Europe as well. I raised the issue of when investors might focus on the question of capital flight out of China, when Tim Duy picked up on the same story. Should the market start to price in the tail-risk of capital flight, look out below!

Then we have the ugly US Non-Farm Payroll Friday. The only good news is that more data points of economic weakness will give the Fed political cover to act and unveil another round of QE. Despite what the central bankers say, don’t forget that when things get bad enough, there will a policy response. As an example of the anticipated response, Mark Dow at Behavioral Macro believes that the IMF is putting on the face paint for a rescue of Spain. While the response may not fully solve the problem, it will kick the can down the road and spark a stock market rally.

A repeat of 1998 in 2012?
Putting it all together, what does it all mean? The market is supported by washed out investor sentiment, but not by valuation. The macro backdrop and momentum looks ugly. Is this the start of another cyclical bear?

My best wild-eyed-guess is that we will see a major air pocket like 1997 (Asian Crisis) or 1998 (Russia/LTCM Crisis) in which some macro event sparks a major selloff, but turns around based on policy response. There are plenty of macro triggers out there. Greece, Spain, China, etc.

Market analogues have limited uses, but look at the chart of the stock market in 1998. The market had an initial dislocation (Greece), stabilized and rallied (as we did a couple weeks ago) and started selling off again. At the nadir of the Russia Crisis that threatened to sink Long-Term Capital Management, the Fed came in and knocked some heads together to save the system.

Now look at the chart of the market this year and last year. See any parallels?

Don’t misunderstand me. This is not a forecast that stocks are going to plunge this week. Analogues are analogies and they are imperfect. Markets are extremely oversold on a short-term basis and I don’t think that we’ve actually seen the macro trigger for a waterfall decline yet, though there are lots of potential triggers.

Not enough pain
Nevertheless, were this scenario were to play out, it suggests that we haven’t quite seen enough pain and we need one more capitulation down leg to equities. For now, my Asset Inflation-Deflation Trend Model remains at a deflation reading, indicating that the model portfolio should be primarily positioned in the US Treasury market. I will be primarily using that model and some short-term timing tools to try to spot the turn. Here is what I am watching. The chart below of the Euro STOXX 50 is falling, but not quite at the lows delineated by the 2009 and 2011 lows. Wait until the index approaches that zone and watch for signs of a “margin clerk” liquidation forced selling in the panic.

Here in Canada, I am also watching the ratio of the junior TSX Venture Index to the more senior and established TSX Composite. While there is a lot of pain, utter and blind panic hasn’t quite set in yet.

When the blood starts to run in the streets, official intervention will be all but inevitable. At that time, that will be the opportunity to buy the pain in Spain.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Just as soon as dollar-euro broke 1.25, it broke 1.24, and there is really no important support until 1.19ish. The bigger and growing risk is that the euro breaks up and it is destabilizing to the markets for several years. US traded European ETF (VGK) is within 2% of the 2010 and 2011 lows, so it is time for the ECB to step it up.

That could mean we are on the doorstep of a “risk-on” short covering rally, which could see the TSX jump at least 3-5% or a bit more. The time line for a catalyst is likely through the June 20th FOMC and the June 17th Greek election, so we could see some bumpy days in between.

Expect WTI to fall back to at least $80ish and Brent below $100 before energy finds its footing. We are seeing some degree of divergence with oil stocks holding in a bit better than WTI, notwithstanding yesterday’s 3.3% clocking. Building exposure to the energy sector for longer-term investors is making sense on valuation, but risk of lower lows in the coming months is still reasonably high.

As expected, the Latin quarter of the eurozone ganged up on Germany on the issue of eurobonds, but Angela Merkel stood fast. But Germany is becoming increasingly isolated. The WSJ report that Christine Lagarde of the IMF came out in support of the concept of eurobonds:

International Monetary Fund head Christine Lagarde Tuesday called on euro-zone governments to accept more common liability for each other’s debts, saying that the region urgently needs to take further steps to contain the crisis.

“We consider that more needs to be done, particularly by way of fiscal liability-sharing, and there are multiple ways to do that,” Lagarde told a press conference in London to mark the completion of a regular review of U.K. finances.

So did the OECD:

Her comments came an hour after the Organization for Economic Cooperation and Development had, for the first time, endorsed joint bond issuance in its latest Economic Outlook

Angela Merkel’s staunchest ally has been Mario Draghi of the European Central Bank. Up until now, Draghi had been relatively silent on the Greek crisis. He spoke yesterday at at the Sapienza University in Rome and addressed the latest eurozone crisis in an unusually frank manner [emphasis added]:

We are living at a critical juncture in the history of the Union. The sovereign debt crisis has exposed serious weaknesses in the institutional framework; in this context, the difficulties in finding common solutions are having a negative impact on market valuations. The extraordinary measures taken by the ECB have gained us time; they have preserved the functioning of monetary policy.

But we have now reached a point where European integration, in order to survive, needs a bold leap of political imagination. It is in this sense that I have referred to the need for a “growth compact” alongside the well-known “fiscal compact”.

He went on to explain what he meant by a “growth compact”, namely closer economic integration:

A growth compact rests on three pillars and the most important one, from a structural viewpoint, is political: the economic and financial crisis has challenged the myopic belief that monetary union could remain just that, and not evolve into something closer, more binding, into an arrangement whereby national sovereignty on economic policy is replaced by the Community ruling. If the governments of the Member States of the euro define jointly and irrevocably their vision of what the political and economic construct that supports the single currency will be and what the conditions to reach that goal together should be. This is the most effective answer to the question everyone is asking: “Where will the euro be in ten years’ time?”.

The second pillar is that of structural reforms, especially, but not only, in the product and labour markets. The completion of the single market and the strengthening of competition are crucial for growth and employment. Labour market reforms that combine flexibility and mobility with a sense of fairness and social inclusion are essential.

Growth and fairness are closely connected: without growth, and the events of recent months also reflect this, the temptation to “circle our wagons” gains strength, and solidarity weakens. Without fairness, the economy breaks up into multiple interest groups, no common good emerges as a result of social and economic interaction, and there are negative effects on the capacity to grow. Recent Italian history has no shortage of examples.

By fairness, he refers partly to the high level of youth unemployment compared to the entrenched older generation with their job security and gold-plated pension plans:

In the European Union, between 2007 and 2011 the unemployment rate rose by 5.8 percentage points among the 15-24 year olds, by 3.5 points among the 25-34 year olds and by 1.8 points in the 35-64 age range. Qualitatively, the profile is similar almost everywhere; the clear exception is Germany, where the unemployment rate among 15 to 24 year olds in the first quarter of 2012 was 8%; in Italy it was 34.2%, in Spain 50.7% and the euro area average was 21.9%. These trends reflect a fundamental question: they confirm the particular vulnerability of this essential part of our workforce. The unequal sharing of the “cost of flexibility”, only affecting young people, an eternal flexibility with no hope of stabilisation, leads among other things to companies not investing in young people, whose skills and talents often decline in jobs with low added value. The underuse of their resources reduces growth in various ways: it makes the creation of start-ups less likely – and they are on average more innovative than others – it causes a decline in skills in the long run, slowing down the assimilation of new technology and acting as a brake on efficient production processes. In addition to undermining society’s sense of fairness, it is a waste that we cannot afford.

In addition, Draghi endorsed the idea of pan-European infrastructure bonds:

The third pillar is the revival of public investment: the use of public resources to push forward investment in infrastructure and human capital, research and innovation at national and European levels. (The proposed strengthening of the EIB and the reprogramming of Union structural funds in favour of less-developed areas go in this direction).

An endorsement of closer economic integration? A advocate for pan-European infrastructure bonds, which is the first step in the slippery slope to eurobonds?

It sounds like Merkel is losing her last ally in Mario Draghi. Expect the Germans to bend sooner than later.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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